Weighing the investment implications of climate change policy
Coordinator: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.
Jean Walshe: Welcome, everyone. Thank you for taking time to join us today. My name is Jean Walshe, and I'm a client advisor in the North American institutional business here at JPMorgan Asset Management. As part of our 2021 long term capital market assumptions, which were released last week, we published four thematic papers underlying the assumption.
Our call today is dedicated to one of those themed papers, the investment implications of climate change policy and the paper can be found on our website at www.jpmorgan.com/institutional/LTCMA.
I'm pleased to introduce the authors of the paper, my colleagues Jennifer Wu, Head of Sustainable Investing for Asset Management, Ben Mandel, Global Strategist in our Multi-Asset Solutions Group, and Vincent Juvyns, Global Market Strategist.
So, climate change and economic policy is a very timely topic around the globe, and one that impacts all of us both personally and professionally. Today, we aim to demystify climate change investing by addressing three key areas: what climate change means for economics and policy, what the impact is to markets and asset prices.
Jennifer, Ben, and Vincent, great to have you all on the call today.
Jennifer Wu: Great to be here.
Ben Mandel: Thanks, Jean. Great to be here.
Vincent Juvyns: Thanks, Jean. Great to be here, indeed.
Jean Walshe: Great. So let's start by level setting with you, Jennifer as the head of sustainable investing for asset management. Can you comment on what's happening around climate change policies, the impact of technology and how investor and consumer expectations are changing? And has any momentum been lost with COVID?
Jennifer Wu: Absolutely, Jean. Let's do a little bit of level setting and then we'll come back to the policy side. So let's start with climate change, right. Climate change is a global crisis. We have seen how there's been unprecedented increase in concentration of carbon dioxide in the atmosphere and that's global temperature is already one degree Celsius above the pre-industrial average.
And what that means is that on the physical impact side, the science already shows that how over time with stronger positive carbon cycle feedback, extreme weather will have material impact on agriculture, human health, mortality, labor, productivity, and even increase in crime.
To prevent the worst from happening, there is greater recognition now that changes need to be made to how we produce and consume on a daily basis, in order to drastically reduce our environmental footprint. And the reality is also that we have more technology than ever before and we have really come a long way with innovation.
It's not just the energy sector with solar and wind as renewables. There is also electric vehicles and battery storage technologies that are already two I think everyone would agree dominant forces today. There is also energy efficient farming, precision agriculture technology, so on so forth, we are talking about innovation across all sectors.
And I think one key thing to remember is that climate, as we said in the report is a public good, global public good. So climate transition policies cannot be ignored when we look at the economic cycles, which is what LTCMA this year is about, especially when both physical and monetary measures are heading towards the same direction to address the climate crisis.
As an example, in Europe, we see how the European Green Deal of 1 trillion euro plus the European Central Bank, making climate at the center of its mandate for asset purchasing. And on your point with regards to COVID, I think in my view, the momentum hasn't really been lost with COVID.
In fact, the pandemic has really acted as a facilitators, not only it has raised awareness amongst investors and corporates about the potential impact of systemic issues such as the pandemics, climate change, but also to have policies very good lesson about the importance of being prepared.
So all in all, I think it's really, really important to understand how these different climate policies are going to play out. And what is their impact on macroeconomic news, not 20 years from today, but really starting from now and that's what our research has set out to do.
Jean Walshe: That's great. So, clearly important and impacting all of us every day and from a macro perspective. In the paper, you write that transition to a low carbon economy could be stick faced with governments mandating sustainable behavior or carrot spaced with governments incentivizing green behavior through subsidies.
Then as a global strategist, can you give us some examples of these two approaches and how they could impact economies and markets? And importantly, also, what are the implication for our LTCMA?
Ben Mandel: Thanks Jean. So, just to start out, it's a tricky proposition, trying to figure out what this means for economic growth over the next 10, 15 years and that's really what we're trying to do, and our long term capital market assumptions.
As we think about what do we get out of markets over that time horizon, our first approximation, and I think a pretty decent one is what do we get out of the economy? So, what is the global economy and growth telling us over time? And then, of course, we have various risk premia of that level, but that level is super important.
And so really, the question is, what does climate change and to Jennifer's point, what is more imminent climate change policy reactions mean for those growth outcomes over the next 10 to 15 years? And I think I compartmentalize it into two parts.
First, is what is the effect on real GDP, or real growth and then what is the effect on inflation? On the first one kind of counterintuitively, climate change does not appear to be a huge directional influence on real GDP growth over the next 10 to 15 years.
I say counterintuitively, because we started this project, my strong prior was that there's a kind of negative convexity in our numbers coming from climate change, but I think that's a bit misleading in the sense that, that negative convexity is a really much longer term issue.
So what we're really talking about is temperature rising over the next 70 years, 80 years, and what that does to economic growth. And over that time horizon, there's clearly a lot of downside risks, as higher temperatures feed back into an array of negative externalities for growth.
But really, what we're dealing with is how do we get the incentives right over the next decade, for that transition to take place and what is the cost of getting that transition underway? And so really, what you're talking about is something on the order of one percentage point of 2030 growth, that you're trading off for anywhere between 5 and 10 percentage points in the year 2100s.
So, we're making those long term tradeoffs over time and over the next decade, what we care about is that transition cost, which ends up being low on average. You know, if you just take one percentage point and amortize it over a decade, it's not huge in the context of our assumptions.
The other thing is timing. So, there's a whole array of different timing outcomes that could transpire vis-à-vis that policy response. You could have a green new deal where we front loaded the transition, see some evidence that that's gathering pace in some places, but not all.
On the other hand, you could have a climate Minsky moment in the event that really, governments don't get their act together in terms of climate regulation, and the private sector is late to the game and then it's more back loaded and disorderly. So we don't have a strong view on which one that is, other than to say that we've already seen a lot of progress and momentum and policy that's begun. So maybe not a shift - I guess it's not going to be that backloaded chaotic outcome, it'll be a little bit more front loaded. But there's nonetheless a lot of uncertainty around that.
And so, small average effects on growth, a lot of uncertainty around the timing over the next decade. I think we're in a position to be a little bit more concrete about the effect on growth and on inflation. Climate change is one of several factors that will contribute to upside this two inflation over the next 10, 15 years.
As the person who helps contribute to inflation forecasts for long term assumptions, I can tell you, it's been kind of a sleepy area over the last few years, in the sense that all the factors driving inflation were pointing in the same direction, which was lower inflation. That's technology adoption, demographics, globalization, monetary policy, having difficulty at the zero lower bound, all those things suggested spending a lot more time at low levels inflation than high.
I think what's interesting this year is that several of those factors have shifted into neutral and some have actually pushed to the other side of the ledger as upside risk to inflation. And we're adding a few additional risks, including climate change to the things that could cause inflation to rise in due course over the next decade.
And so climate change is another finger on the scale on our inflation outlook and I think that's a very important narrative in thinking about where's inflation in 10 years’ time? What are interest rates in 10 years’ time? What are parts of the economy and markets that benefit or lose as a result of those higher inflation outcomes?
So it's a very significant implication for the way we think about the long term. All that is to say that we - climate change is a very important aspect of the risk profile around our overall return assumptions, but there's some nuance there and it's not just about physical risk.
Jean Walshe: Thanks, Ben. Shifting from the macro that you described to more micro, Vincent, you're sitting in Luxembourg at the moment, given your experience as a global market strategist, could you shed some light on changes taking place in different countries and regions and how to think about investing differently in equity markets, for example?
Vincent Juvyns: Yes, certainly, Jean. And Ben just finished with the statement, it's not the only physical risk and indeed, it's about risk of policy change, change like Jennifer alluded to in her introduction, we see that climate change is real. It is actually becoming a bigger problem, which needs to be addressed by policymakers quite rapidly.
And some are doing actually a pretty good job, some are a bit more advanced than other in the space. And what we really looked at in our research paper is not the impact of the physical reach, but clearly the impact to the policy risk. What does that mean?
And you alluded to Jean in your questions, just the policymaker can use more covered based approach or more (stick) based approach. We are probably more likely to see both given the challenge that lies ahead of us. In Europe, most countries we named so far signatories of the Paris Climate agreements, we all know that it's not sufficient anymore. Jennifer, reiterated that where we are, where we are there in our let's say climate ambition, we are behind the curve, clearly and COVID provided only temporary relief in this respect. So, we need to go beyond this.
And we have heard recently, many countries pledging to get to carbon neutrality by either 2050 or 2060, that being the case, the UK or Europe or China more recently. We may in see it in the US as well in January, that's one of the mystery of the commitment of Joe Biden, one of the key elements of his program.
So really, it's not a theme, which is in over 10 -15 years, which is already playing out at the moment and carbon neutrality by 2030. This means reaching peak emission in the next 10 years. So, countries are using and we see it in Europe at the moment of just the carbon based approach and we may see that in the US as well.
And Ben mentioned the positive impact that it can have from an economic perspective, this can obviously offset the negative coming more from a (seat) based approach, but coverage clearly include massive fiscal stimulus. We have already alluded to the Green Deal in Europe, but it's not the only thing that we have in Europe at the moment.
We had also a couple of years ago with the so called Juncker plan, or the European Central strategic investments, which also revived investments in the region into infrastructure, into renewables, into research and development, in all these fields and something we may have seen in the US as well as there also the Democrats have announced a $1.7 trillion stimulus to obviously invest in infrastructure.
So, this coverage based approach is going to generate opportunities and we'll be discussing later during this call for what it means for infrastructure, for alternative asset, and so on. But clearly it’s opened up opportunities for a lot of business, you made as an investor to be aware of it, to be focused on those business, which can capture those growth opportunities driven by the covered based policies which are deployed by government.
We need also to be aware that it's not going to be sufficient. We're going to hear stick based approach as well. What does that mean? Often it seems higher carbon price. Carbon tax has been discussed quite a lot already, globally, but it's something which is gaining traction, maybe not in the form of a tax per se.
But you know, we have this so called emission trading scheme globally, which was developed in Europe, which allow India to price carbons and in Europe at the moment, the metric ton of carbon is priced at roughly $30 per metric ton of CO2, which is quite high, not enough to meet our climate goals, but it's much higher than globally.
If you look at the average price globally that the US company or global company would be confronted with. It's around $2.00. So, so far this higher carbon pricing in Europe has been pretty much a headwind for European corporates. We have to face higher internal cost than our global peers.
But things are changing due to the fact that more and more countries are using this stick-based approach. We see that as of next year, China is going to deploy thanks to the merger of several regional emission trading scheme, the largest emission trading scheme in the globe and will join European space.
So, we have one certainty is that carbon prices are only going up and even for those who don't have their own ETS system in place and who don't apply those higher carbon price, they will be charged anyway because those countries which has the system in place, are going to implement a border, a carbon border adjustment mechanisms, which are already discussed at the moment between Europe and China to give you an example.
So, it's really from an investment point of view and your question was more on the micro, it's a duty for us as investors to identify, the relative winner and loser of the deployment of those policies globally. It's not about good or bad countries, good or bad sector, it's about those who can adapt.
And in our research, we looked at from a country perspective, those which had the physical capacity to adjust to climate change, to decarbonize their economies. You see that - you see countries like Russia, India, South Africa, but also Canada will experience difficulties because they score very poorly on these metrics while countries, obviously, like Europe, Switzerland, Japan, score much better.
Also, from the sector perspective, really, the idea there is not to be a climate advantage, it's about really looking at the relative winner and loser within every sector. It's not about being long, renewable, and short for the (purist).
It’s identifying with each sector, those who can produce the same goods and services with a lower carbon intensity, because carbon prices are going up, so a higher carbon intensity means over time, lower margins, and lower performance for investors.
So clearly, for us it is one of the consequences that we derive from these policy developments. This could have obviously have effect in terms of leadership from a regional perspective. We have seen over the last 10 years that the US was clearly leading on financial market. It was something so good, like the US exceptional easement judging these devices in the tech sector, this may change.
The countries which have invested the most in this new green economy, which is unfolding at the moment, are Europe, for instance, which invested for many years in R&D initiatives with use fiscal support to really support these realistic economies or even China.
When you look at China, even with China, one of the biggest greenhouse gas producer globally. It produced 72% of most solar modules, 69% of lithium batteries, and so on and so on. So, these are the type of conclusions that we can draw from the microeconomic perspective on financial markets, which we believe are very important for investors listening today.
Jean Walshe: Thanks Vincent. And Jennifer, for our institutional investors, what advice do you have? Is this a directional bet on growth or what would you say to investors who are so hesitant or maybe on the fence about climate related investments?
Jennifer Wu: Yes, that's a great question. If we just think about the scale of how much of our economy like Vincent was saying needs to be decarbonized, in order to keep the global temperature rise at below 1.5 degrees Celsius.
I think you can quickly realize how big of an investment this actually represents, as we need to revamp almost our entire infrastructure. So in my view, this really is a what I call a once in a lifetime type of opportunity, because we're really looking at the retirement, rehabilitation, and the rebuild of infrastructure at massive scale.
So, the first thing that I think investors need to look into, is to ask the question around what assets in your current portfolio is potentially at risk? And also, what investors need to focus on is to identify like Vincent said, who are better positioned compared to their peers across key sectors, such as utility, transport, energy, machinery, and even the model.
And let's not forget, on the other end of the scale, there are lots of new investment opportunities right, there everywhere from how we source energy, produce electricity, consume water, heat our houses, move from one place to the other, all of these represents, in my mind, a new asset class that can generate steady income for investors and I think that's something that we should keep in mind as we move into the new economic cycle.
One thing really interesting is that if you look at it, many of these technologies are actually owned by new ventures and private companies. So, another good reason as to why we need to think about climate change as we look at allocation to alts.
We, also I think, need to be quite mindful of climate policies that are already in place and their impact on global companies. Because we know that in different jurisdictions and countries, these things are continuing to be evolving. But if we look at, for example, internationally, new policy agendas, such as cross border adjustment tax and the EU, that is going to impact companies that do business either in Europe or with European companies.
So, it's going to be really difficult for private sector companies alone to solve this. And that is why government support and physical support is a must in order to turn say US companies equally, if not more competitive. So I guess, what I would recommend is that in conclusion was all of these government policies such as green subsidies, direct investment in R&D, as well as regulations around energy efficiency, emission standards, and on top of all of the technology advancement that we talked about, carbon transition has to be top of mind for investors, when they consider their capital allocation.
It's not a directional bet on growth, it is just something that needs to be integrated into how you think about asset valuation, credit rating, strategic asset allocation, because it is going to impact every part of your portfolio.
Jean Walshe: Thanks, Jennifer. That's sage advice. Just to turn back to Vincent, for just a brief comment. We mentioned some alternatives markets. Can you just elaborate just a bit on maybe some examples in alternative markets, the low carbon economy impact, please?
jea Yeah, you're right, Jean and maybe just to start, we should mention what we do a JPMorgan in this field. All macro funds of JPMorgan, global macro opportunities, invest in a thematic way and at the moment, the climate change theme accounts for almost 10% of the strategy.
So, to show how important it is for micro funds (unintelligible) and Jennifer alluded to already at the need in terms of the infrastructure globally, definitely in the space of climate change to address climate change. This is a huge opportunity for investors. We need to be aware that there needs to be a feeling of use that builds up this year to cope with the COVID crisis. Governments can support investments in this area, but there are limits to what they can do.
What we've seen in Europe, is that Europe has worked in a private public partnership way, so far, so really putting public capitals and real leverage on private capital to really increase the firepower of public investment.
And when you look at actually the program of Joe Biden in the space, it is also his ambition to really put $1.7 trillion on the table, to really leverage from private capital to really do even more in this field. So which is a huge opportunity for private investor, which going through infrastructure finance really has there in these fields.
This is something which players across the board within our alternative platform, just thinking about the transportation business, JPMorgan, we have invested in new L&G ships, which can carry liquefied gas with less fuel consumption. They consume up to 60% less in energy. We need those ships to reach all major, for instance.
So, it is also a way to really address climate change in our transportation business. So really, across the platform, from micro firms to infrastructure, to transportation, and even within private equity, Jennifer briefly alluded to, we are looking at really new startup in the green fields, which offer great also opportunities for our portfolio managers. So, really a huge theme across the entire platform on the alt space.
Jean Walshe: Thank you so much Vincent. Ben, which countries are positioned to most effectively address climate change? I know Vincent mentioned a few at a high level, perhaps EM versus DM or more specifically, what does it mean for investment opportunities specific to certain countries?
Ben Mandel: Yeah. I think there's a fairly clear EM versus DM implication here and it's an extension of what Vincent and Jennifer were just talking about. I mean, they're talking about immense heterogeneity across firms, across sectors, across countries.
You know, as we think about a broader story in our long term assumptions, the story of international diversification is one where this year I think we have maybe more confidence than we have over recent years, that US equities are not going to dominate over the next 10 years in the same way, as they did over the prior decades.
And, you know, that story has different aspects to it, part of it is valuations, you know, US equities are more expensive. Part of it is the dollar and the expectation that the dollar depreciates over time giving a tailwind to those unhedged US dollar portfolios. And the other is about growth, you know, where's the growth in the world?
And the answer to that has been emerging markets, which is part of that diversification story. So, I think climate change is kind of a caveat, an important caveat to that idea. As we think about emerging markets, growth, emerging markets, equity, composition, emerging market policy, all those things have a different character to them in the next decade than DMs in what sense?
In the sense that DM economies themselves are more carbon intensive, the equity indices, in other words, the firm is surprised that you're actually buying when you buy MSCI EMs are more carbon intensive on average than their developed market counterparts.
And, you know, it does a similar thing, the whole carrot versus stick approach is predicated upon how much fiscal policy is being used to kind of get the incentives right, rather than just sort of brute force carbon taxes. And so there's just less political space in emerging market economies, on average than developed market economies and so a little bit more constraint there.
So, I guess the way I'd characterize it is that that diversification story is really gaining traction, you know, US versus the rest of the world. And then what China does is kind of tilts that left the world application slightly in favor of the non-US, non-EMs allocation. So something like (EFA) looks good on that score.
And as we were discussing earlier, that's an area where actually, you know, they take you down the front foot, these are the climate policy and actually using the physical space where available to counteract the negative near term growth effects. So a little bit spread out in terms of those expected returns.
Jean Walshe: That’s great. Thank you, Ben. Vincent, maybe perhaps you can comment on how the energy sector is expected to fare with climate change policies, and what should investors look for in the energy sector?
Vincent Juvyns: Good question, Jean. And typical of VC directors in the room, and most of just make it possible victim of all the better. It's not the end of the energy sector, but it pervades the beginning of the end of the energy sector as we know it. So, this sector like a lot of other sectors are going through a major transformation, which will affect inequality on corporates and there will be winners and loser like in like in every sector.
So, and clearly that there are different reasons to differentiate between different energies companies, first and foremost, because not every company extract all in the same way. Some ways are more polluting than others obviously, so that’s already a very important point. Some have already done a lot to reorient their business to get carbon, their business, away from something of fuel versus facility energy.
We take the example in a research paper of BP, which is actually set a very ambitious decarbonization strategy with a 40% decline in oil and gas production, and to really invest massively in green energy. And what we already see is that those strategies are really bearing fruit.
You see that it is reflected in the relative valuation of these companies, those which have managed to already transition to new types of energy, really are trading at a premium on financial markets, which is also an element we have developed in our research paper.
So, in the energy sector, like in every sector we start looking at the relative winner of the energy transition, those who adapt the fastest, because carbon prices are going up, that's a given, but those who do not decarbonize enough, will also see, and face a higher cost of capital.
It is more and more difficult for investors to really finance a corporation which do little or too little in terms of decarbonization. So, clearly, the transition, the early adoption, adaptation, either is key for the energy sector and we have seen a lot of success of big major transforming themselves.
So, it's not the end of the energy sector, but it's a sector which will go through new transformation, and it's up to active managers to really identify and invest in those relative winners.
Jean Walshe: Thanks, Vincent. Jennifer, how much of that is priced in for investors that people are looking for opportunities to invest?
Jennifer Wu: That's a great question. So, I would say we are really at the starting point of this. And you can see some signs already.
So for example, in our report, we actually look into the oil and gas sector and what we have found is that we're starting to see pretty significant differences within the sector, between companies that are fast, embracing clean energy and are really changing their business models versus those that are not and these differences are slowly starting to be priced in by the market.
So, with everything that's just been discussed by Ben and Vincent, you know, with more ambitious climate policies in size and purely from an investment standpoint, this is really about identifying winners and losers. And that it's not just one sector or one country, it's across all sectors in our country.
And it's also not just about public equity, which has been a big focus for especially sustainable investors in the recent couple of years. For example, we can see that companies such as Tesla, or in Europe (Orsaid), they are really already trading at pre-IPE. And that is why I think it resonates well with what we’re saying this year in LPCMA thinking about how getting capital to the old space. Because I think while there are still lots of interesting opportunities in the public equity space when it comes to identifying climate transition winners, but you want to look at other parts of your portfolio as well.
So, for example, in a fixed income space, we all know about green bonds. This is a market that has really grown quite a lot, especially in the last five years with steady growth in both supply and demand. And currently the market size is under 13 billion, which is not small.
So, if we think about how green bond has been trading, yes it’s true that currently green bonds don’t seem to offer a significant advantage in terms of financing costs for their issues, especially when you compare it to traditional bonds.
But, you know, we believe that with the intervention of central banks, like in Europe for instance, it will likely increase demand and it’s going to reduce the yield of the bond relative to other assets. And I also want to highlight that in (space’s) green bond it’s quite important to recognize that at the pre-pandemic period.
Green bond was already at a point whereby demand was surpassing supply, so there was reason for investors to consider green bond for allocation and that climate policy and how much that kind of influence yield in green bond hasn’t really been fully priced in yet.
And then the final point I will mention is that there is also much greater diversity now in different types of financing in fixed income space for green and clean projects, such as transition bonds, as another example. These are not your typical green bonds because these are typically issuers or projects that are currently in various what we call, like, highly polluting industries, and they don’t fall under their current green categories.
But what they do is going to have a very, very critical impact on whether we can achieve the clinical that we set out to deliver. And these would be examples like mining, cement and steel, aviation, transportation, et cetera.
But all in all, the good news is that we’re really at the start of this great global transformation. So, I think by moving in early before these risks and opportunities are fully priced in, we believe that investors can capture substantial return as prices continue to adjust.
Jean Walshe: And that sounds very promising. Thank you, Jennifer. Thank you, again, for participating today.
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